May 26, 2015

As insurers begin to consider their product offerings for next year, they have had their first chance to look at a full year of data from the new customers in their ACA exchanges plans. We bet this was a sobering experience, because last week came the news that many exchange health plans are seeking double digit rate increases. Blues plans in New Mexico, Tennessee, and Maryland have all asked for increases of 30 percent or higher. The largest insurer in the Oregon exchange is asking for a 25 percent increase and many other insurers have stated that they are not far behind.

How far we’ve come from the celebratory statements from the Obama administration about the low premiums in the first year of the exchange and the recent small rate hikes for non-exchange plans. But if anything was to be expected, it is exactly this outcome: large increases during the first years of a new insurance market. While insurance industry critics will undoubtedly blame the increases on market failures, price gouging and the rapacious greed of industry executives, the reality is that these increases demonstrate that the exchanges are functioning the way they were intended – as vibrant and competitive but still nascent marketplaces.

Like any new product marketplace, the competitors in the exchanges are still trying to figure out the value created by their product and the costs of bringing that product to market. And there are some dangers in this process – markets can be messy – but it is far too soon to give up on this most promising aspect of Obamacare. However, it is time to accept that even fairly priced health insurance is going to be expensive in a nation where health costs run so high. If anything, buying new insurance products from new exchanges only increases the volatility of insurance premiums.

When it comes to understanding the pricing of health insurance, particularly new insurance products, a little economics (and a soupcon of business strategy) goes a long way.

When any business offers a new product the price they charge amounts to an educated guess. They attempt to determine demand for similar existing products, and then extrapolate from that across the different dimensions of their new offering. For traditional product markets, this involves having a really good sense of the cost of producing the product and estimated information on customer demand. The more novel the product, the less the price is educated and the more it is guess. When the new product is health insurance sold through new exchanges, the problem is magnified, because insurers don’t have a good sense of either costs or demand. Most critically, insurers had to guess about the health risks of their enrollees. The Obama administration had hoped that the ACA’s subsidies, mandates, and penalties would encourage a representative share of low risk individuals to sign up. Evidence from enrollment in the exchanges suggests that enrollees ended up older and lower income than expected. Insurers may not have been as optimistic as the administration, but even the most pessimistic of insurers appear to have failed to anticipate the selection in the market. Insurers who were burned by this unfavorable selection in the first year are using this opportunity to recalibrate their premiums to more appropriate (i.e. at least breakeven) levels. Megan McArdle examined the filings requesting these rate increases and found some startling losses for many insurers. For example, Moda insurance in Oregon had negative 60 percent in its first year, and they are not alone. Only now do insurers have enough data to figure out what’s driving these losses and price accordingly.

Even if insurers guessed right in the first year, they know from experience that attrition in insurance markets tends to adversely affect risk pools, as the sick and old reenroll at higher rates than the healthy. This is particularly true if insurers are forced to raise prices and the marginal customers drop out of the insurance pool. This is one reason why rapid price increases are common for new insurance products outside of the exchange, and helps explain the recently discussed price hikes in the exchange.

The third reason for the rate hikes combines a bit of behavioral economics with business strategy. Research shows that most health insurance enrollees who do not drop coverage display considerable inertia. That is, they often spend a lot of time when first choosing a plan, but once enrolled they tend not to switch, even if there are opportunities to save money by doing so. Some economists estimate that this inertia can cost enrollees thousands of dollars annually. Health plans that were aware of this inertia would have a big incentive to lowball premiums for their new exchange offerings. By pricing below costs in the first year they would gain valuable market share. They can then recoup any losses by increasing premiums to their “loyal” (or more accurately “passive”) enrollees in later years.

In addition, regulations contribute towards this inertia and pricing strategy. For example, features of the law that limited the losses an insurer could face in the first few years, such as risk corridors and reinsurance, may have unknowingly contributed to this gaming behavior. In addition, low income enrollees received fixed subsidies based on premiums for the second cheapest silver plan. This would explain the pattern of low initial prices and the high increase in premiums in later year. Firms know that the plan which offers the second cheapest silver premium in the first year of an exchange likely attracts the most customers because they would be the benchmark plan used to set the subsidy. As long as all insurers begin to price at cost in the future then the market share of the originally artificially low price plan will remain high and that company profits.

Last but not least, health care spending is growing, and last year may have seen a new spike, due to rising drug costs and the exercise of pricing power by concentrated providers. We will soon learn about premium increases for non-exchange plans and from this we can infer how much of the increases in the exchange reflect basic economics of the health care market – which unfortunately point to higher prices in the future. In my opinion we have lots to learn from the Europeans, their e111 form takes care of almost all basic needs. We shouldn’t be limited by a us vs them attitude about this.

Call it normal market forces, or call it “price gouging” if that is how you must describe firms charging a market clearing price. But the big takeaway is that in the first years of a new insurance market, we should be surprised if pricing did not follow the very pattern that we are now witnessing in the exchanges. And that may very well be good news, because the same economic forces suggest that premiums will quickly settle down, as risk pools stabilize and strategic entry pricing becomes less relevant in mature markets.
However, there is a dark side of competitive insurance markets that must be acknowledged. As insurers raise prices to cover their sick populations, we know that they may chase out the healthier enrollees. Consider again the case of Moda in Oregon, which lost 13,000 members last year when they raised prices by 10.6 percent. What is keeping insurance executives awake at night, and what should be worrying Obamacare supporters, is the possibility that those who leave are the young and healthy enrollees that have already been far too difficult to attract. These individuals may decide that the fairly low Obamacare penalties aren’t worth the increasing premiums. For example, in the most recent open enrollment people it is estimated that 3-6 million people were required to pay the penalty for being uninsured but less than 200,000 people took advantage of the ability to sign up for coverage upon being told of this penalty at tax time. This suggests that these individuals are making a conscious choice. If this pattern continues and leads to an overall death spiral for the markets, it will be an unfortunate outcome for all involved.

Supporters of the ACA signed on to a plan that relies utterly on competitive insurance markets. However, some of these individuals appear to have been also believed in the fantasy they were sold that the exchange markets were the only thing standing between American citizens and low-cost health care. That’s simply not the case. Now that they have seen exactly how these markets function, let’s hope they don’t have buyer’s remorse and attempt to enact onerous regulations that exacerbate the potential problems in these markets. Rather than bemoan market forces, let’s harness them to make the exchanges even more effective. Over the next few weeks we will discuss plans for insurance design that will help us move towards these goals.

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5 Comments

Excellent commentary on the early responses of the exchange plans – changes that were fully predictable based on historical behavior of insurance markets. A more difficult issue is deciding what role government should play in correcting the deficiencies of the market model. It will be interesting to see your views on insurance design that would make the exchanges more effective. Hopefully you will include in your discussions the option of a well designed single payer model and contrast that with a well designed exchange of private insurance plans.

[…] Our recommendation is simple and not unique to this setting – do not automatically reenroll individuals in the same plan. We are not suggesting that everyone has to sign up anew each year – too many who are currently enrolled will fail to do so and the number of uninsured would increase. While we are both big believers in personal responsibility, such a proposal would be throwing the baby out with the ACA bathwater. Instead, we are suggesting that at renewal time, all individuals are asked to affirm whether they want to keep their plan, switch plans, or drop coverage. Those who do not respond are automatically reenrolled, but are not necessarily assigned to their own plan. There are a number of options for reassignment that would avoid financial surprises – for example enrollees could be reassigned to any plan that cost no more than the second cheapest silver plan. In addition, they could be allocated at random to a plan that matches the distribution of people that actively re-enrolled. There are many positive and negatives to each decision rule and we will allow rule makers to figure out the details. We should note that we are not attempting to force people into cheap plans just to minimize their expenditures. After enrollees are reassigned, they can be given additional time to accept the new plan or pick another (possibly their old plan). What we want to avoid is that a lack of attention is costing everyone money because insurers may be gaming the design of the exchanges and consumer inertia. […]

[…] Our recommendation is simple and not unique to this setting – do not automatically reenroll individuals in the same plan. We are not suggesting that everyone has to sign up anew each year – too many who are currently enrolled will fail to do so and the number of uninsured would increase. While we are both big believers in personal responsibility, such a proposal would be throwing the baby out with the ACA bathwater. Instead, we are suggesting that at renewal time, all individuals are asked to affirm whether they want to keep their plan, switch plans, or drop coverage. Those who do not respond are automatically reenrolled, but are not necessarily assigned to their own plan. There are a number of options for reassignment that would avoid financial surprises – for example enrollees could be reassigned to any plan that cost no more than the second cheapest silver plan. In addition, they could be allocated at random to a plan that matches the distribution of people that actively re-enrolled. There are many positive and negatives to each decision rule and we will allow rule makers to figure out the details. We should note that we are not attempting to force people into cheap plans just to minimize their expenditures. After enrollees are reassigned, they can be given additional time to accept the new plan or pick another (possibly their old plan). What we want to avoid is that a lack of attention is costing everyone money because insurers may be gaming the design of the exchanges and consumer inertia. […]

[…] We support the ACA exchanges because they eliminate this folly. But it is equally foolish and shockingly counterproductive to also require firms to provide insurance. If it were not for this mandate, all firms could offer their workers higher wages and let them find the coverage they want on the exchange. This would level the playing field for small firms and give peace of mind to the self-employed. It would also deepen the risk pool in the exchanges, which is essential to their long term success. […]

[…] We support the ACA exchanges because they eliminate this folly. But it is equally foolish and shockingly counterproductive to also require firms to provide insurance. If it were not for this mandate, all firms could offer their workers higher wages and let them find the coverage they want on the exchange. This would level the playing field for small firms and give peace of mind to the self-employed. It would also deepen the risk pool in the exchanges, which is essential to their long term success. […]